Is China Deleveraging?

A major focus of China watchers is whether China is deleveraging. Like many questions, it is not 100% straight forward based upon the available data, but on balance we have to say. Let me explain.

Despite all the talk of “deleveraging” and how China is restraining liquidity, this simply isn’t borne out by the data. In fact, in many area, leverage is actually growing very very rapidly.

What is confusing the issue for many people is what is and isn’t growing. Conceptually, most people without realizing it expect a bell curve to represent growth and then the average of the bell curve moves up or down. However, in this case, that is not what is happening. Consequently, deleveraging gets confused.

One of the biggest mistakes, in my opinion, is the most common citations of debt are to “non-financial corporates”. The BIS uses this as their primary measure of debt levels for instance. In China think manufacturing and real estate firms. By that measure, there is a degree of deleveraging. From H1 2016 to H1 2017, total loans to NFCs was up only 8.5%. While this is not absolute deleveraging, it is nominal deleveraging in that if we take a simple measure say nominal GDP growth which was 11.4%, debt did not grow as fast as nominal GDP. For various, reasons, this would not be my optimal relative metric but for our purposes here it works fine. This is a small victory but it needs to be considered a small victory. Chinese corporates remain enormously stressed. Small victory but keep it in perspective.

It has even been pointed out that total social financing (unadjusted for local government bond swaps a very key non-adjustment) as a percentage of nominal GDP actually fell by 0.2% in the last quarter. Given that bond swap adjustment will add 2-4% to the TSF, this is not an insignificant adjustment.

The biggest problem with the deleveraging argument however is that it is basing upon nominal GDP growth. This is not an insignificant problem but an atypical one. Nearly the entirety of the surge in Chinese reflation is due to the surge in base inputs like coal, steel oil, and similar metals and commodities. Chinese CPI and retail price index (RPI) are up 1.5% and 0.9% respectively. Business focused price indexes like corporate goods and producer prices reveal the entirety of the surge in price levels is on mining, coal, steel, and related industries. All others are near flat. Metallurgy, coal, and petroleum in the PPI are up 17.4%, 35.9%, and 9% respectively. The average GDP deflated from 2014-2016 was 0.64 while in 2017 it is 4.61% and 4.25% through the first two quarters. The triple digit price gains in traded commodities pushed up nominal GDP growth but is highly unlikely to experience another triple digit surge. Consequently, the price level of these commodities is already falling peaking at some point within the past few months. We can expect it to keep falling over the remainder of 2017 changing the deleveraging argument fundamentally absent major drops in financing.

Another factor of what we see is the surge in non-corporate and quasi-off balance sheet financing. Loans to households and portfolio investment by banks (read WMP holdings) grew by 23.9% and 17.1% compared to the more pedestrian 8.5% growth to NFCs. Nor are these numbers small. Household and portfolio investment combined are now 13% larger than loans to NFCs and growing at a combined rate of 20%. In other words, China maybe slowing NFC growth but other areas are simply exploding and now responsible for a greater share of the debt burden than the part everyone focuses on. To put the level of household debt in perspective, household debt in China is now equal to 104% of household income and growing 24% annually.

While the deleveraging story in China is not uniformly and entirely bad, there remains no fundamental focus on deleveraging. Furthermore, the trends are such that even the glimmer of hope due to nominal deleveraging from surging commodity prices and slowdown in non-financial corporate debt seem likely to fade as other sectors build up debt levels rapidly and prices fall back due to the base effect. It seems we need to wait a bit longer for real deleveraging.